Ch. 3: The American

Free Enterprise

System

Sec. 1: Advantages of the

Free Enterprise System

What is a Free Enterprise System?

Capitalism –

central idea – producers free to produce

the goods and services that consumers

want

consumers influenced by desire to buy

goods and services to satisfy econ. Wants

producers influenced by desire to earn

profits

Free enterprise system –

Example: United States

Monica Ramirez – starts business of

cosmetics for Latinas

creates Zalia Cosmetics

put whole saving account into

business – soon gained backers to

invest in business

outlets in major Hispanic markets –

business growing – gives back to

support Latina Entrepreneurs

One of 585,000 new businesses in US in 2001 – can see businesses everywhere

all examples of how individuals choices are the basis of a market economy

owners choose to start the enterprise

owners choose how to use their scarce productive resources

managers and workers voluntarily exchange labor for pay

consumers choose which goods and services they will buy

Govt. action usually limited –designed to protect or encourage competition or enforce contracts

Example: Emerging MarketsMexican Economy

Govt. plays much larger

role then US govt.

rules and regulations

make starting

business difficult

informal market has

grown as a result –

has driven retail stores out of business

street vendors and

vendors with stalls

Singapore Govt. very closely involved with

economy (Singapore Inc.)

Govt. says what benefits employers must provide employees

Workers must put certain percentage in Central Provident Fund – govt. saving scheme

fund pays pensions, and funds public projects (ed., health care, housing)

Govt. supportive of free enterprise

keeps business rents, taxes and costs low

How a Free Enterprise System

Works

Key freedom – private property – can exchange

it voluntarily – heart of free enterprise

Open opportunity – the ability of everyone to

enter and compete in the marketplace of his or

her own free choice

ensures market reflect wide range of interests

& talents and provides incentive to be

efficient and productive

Legal equality – a situation in which everyone

has the same economic rights under the law

Free contract – for voluntary exchange to work,

people must be able to decide for themselves

Which legal agreement they want to enter into –

business, job, or purchase commitment

What motivates people to start a business?

Profit motive – the incentive that encourages people and organizations to improve their

material well-being by seeking to gain from

economic activities

Producers seek highest possible price for

product

Competition offsets drive and forces prices

down

Helps producers find price that does not

deter buyer or inhibit profits

Example: Profit in Rocks Pet rock – Gary Dahl – a pet rock easier to care for than

regular pets

wrote a manual on pet rocks – training , tricks…

Aug. 1975 – packaged and sold with manual at gift shows

major department store purchased 500

became major story, with interviews and articles

by end of year – sold more than 2 tons – he is millionaire

1976 – consumers lost interest – Dahl gets out of the

business

Example: Competition Over

Books Books different then pet rocks – fierce

competition

before 1995 – small chain stores and

neighborhood booksellers dominate market

1995 – large chain stores – Barnes & Noble Inc.

and Border Group Inc. begin to compete

can buy in high volume and pass savings to

consumer

warm & welcoming atmosphere in stores –reading areas, cafes, book signings

1991 – independent booksellers account for 30%

on book sales in US

by 2005 – down to 15%

between 1995-2005 – 1,200 ind. Bookseller

went out of business

New challenge for chains – Amazon.com

huge database, quick & reliable delivery,

discount prices, easy to use web site

by 2004 – sales at $134 million a week

New challenge for Amazon – Overstock.com

& Buy.com

undercut Amazon’s prices and has excellent service

Consumers benefit from competition

Ind. Booksellers cannot match prices

can provide personal service and focus on local tastes or specialized topics

example of those who keep pace with the

market and adjust accordingly

Economic Pacesetter: Milton Friedman:

Promoter of Free Markets

Economics professor – b. July 31, 1912 – d. Nov. 16, 2006

career teaching at U. of Chicago – free market ideas – “Chicago School of Economics”

Market should be free to operate in all fields – even law & medicine

lowering licensing standards would bring more dr. and lawyers into market

would bring down costs of services

Govt. most important role is to control the amount of money in circulation

with no control, economy would experience inflation

Advisor for 2 presidents and head of state for several other countries

1976 – won Nobel prize for Economics

1980 – wrote Free to Choose –best seller nonfiction

1977 – 2006 – served as scholar at Hoover Institution, conservative public policy research center at Stanford University

Sec. 2: How Does Free

Enterprise Allocate Resources

The Roles of Producers and

Consumers

Profit – the money left over after the costs of

producing a product are subtracted from the revenue

gained by selling that product

Seeking profit is one way producers help allocate

scarce resources in the economy

Example:

Producers Seek

Profit

Neighborhood coffee shop

owners charge highest price consumers are willing to pay

possibility for good profit encourages other to open shops

productive resources got to the coffee shops instead of other businesses

profit seeking helps in allocation of resources

Example:

Consumers Vote

With Their Wallets

When consumers buy a product, they vote for it vs. another product

votes determine what will be produced in the future

ex. – low carb diets –interests peak and fall –producers respond based on votes of the

Consumers-consumer actions cause a reallocation of resources

Government in the US

Economy

Modified free enterprise economy – includes some govt.

protections, provisions, and regulations to adjust the free enterprise system

Modified Free

Enterprise

Figure 2.4 showed flow of resources and products moving in a circular flow between businesses and households

Figure 3.4 shows how govt. fits in

Govt. exacts costs and gives benefits

green arrows show flow of money

blue arrows show flow of products and resources

govt. is both consumers and producer

consumer in the resource market –spending to buy factors of prod.

consumer in product market – spending money in exchange for products

a producer – providing goods & services to households & businesses

collects money from businesses & households in form of taxes

covers costs of what is produced with this money

uses money to make purchases in the resource and product market

Figures 3.5 & 3.6 – show govt. a major consumer of resources and products

govt. employs about 22 million workers –16% of labor force

govt. consumption is over 2 trillion

Sec. 3: Government and Free Enterprise

Providing Public Goods Most production decisions made in the marketplace through the

interaction of buyers and sellers – the free enterprise sector

decisions made by different levels of govt. – the public sector

which sector produces a good or service?

if all costs borne by and benefits go to the buyer and seller, the free enterprise sector

Market failure – people who are not part of the marketplace

interaction benefit from it or pay part of the costs

when this happens – govt. sometimes provides goods or service

Public goods – goods and services that are provided by the govt.

and consumed by the public as a group

public goods are funded with taxes

Example: Characteristics of

Public Goods

Public goods have 2 characteristics:

1. people cannot be excluded from the benefits of

the product even if they do not pay for it

2. one person’s use of the product does not reduce its

usefulness to others

Street lighting

Impossible to exclude people

from using it

the benefit is not diminished

because other people use it

no way for private business to

establish a realistic price and

collect

local govt. provides and

collects taxes to cover cost

National defense

Everyone benefits from it

the benefit is not

diminished because other

people feel secure

Given the benefit – you

would readily pay for sense

of security

Everyone pays through

taxes to national govt.

Example: Free Riders

No incentive for business to produce public goods –

people will not voluntarily pay for it

people receive the benefit of these goods whether they

pay or not

Free rider – is a person who chooses not to pay for a

good or service but who benefits from it when it is

provided

one type of market failure

Fireworks Shows

Shows are very expensive – no way to charge people for watching the show

can charge for a very good spot, but others will still be able to see it

those who do not pay – free riders

Little interest in providing fireworks displays as a business opportunity

to address problem – govt. to provide certain goods and services

city govt. puts on the show and pays for it with taxes

costs and benefits shared throughout the community

Police Force

Everyone is protected

whether they pay or

not

best way to ensure

that those who benefit

pay their share is for

govt. to provide the

service by paying for it

with taxes

Public and Private Sectors – Shared

Responsibilities

Some goods provided by either sector

often toll goods – goods consumed by the public as a

group, but people can be excluded from using them

open for all to use, but have to pay a toll to use

initial funding for toll goods is provided by the public

sector, but day to day is provided by the private sector

Public and private share

responsibility for the nation’s

infrastructure

Ex. – highways, mass transit,

power, water, sewer systems,

education, health care

systems, fire and police services

if not have these things –

economy would come to a

halt

lose ability to move troops in

case of attack and evacuate

in emergency

Infrastructure – essential to

economic health

Managing Externalities

Externality – a side effect of a transaction that affects someone other than the producer or the buyer

Negative externality – is an externality that is a negative effect or cost for the people who are not involved in the original economic activity

ex – manufacturing company discharges pollution into a river – cost of pollution is borne by those who live near the river – even if no connection to company

Positive externality – is an externality that is a positive effect or benefit for people who were not involved in the original economic activity

neighbor plants a rose garden – everyone benefits from beauty

Example: Paying For the Negative

Externalities

Industrial pollution

Company has little incentive to

pay extra to reduce pollution

those living around it are going

to suffer from it, bear the cost

of clean-up and bear the

medical costs if ill

Limiting negative externalities is

important role of the govt.

govt. taxes or fines polluters

money raised can offset higher

medical costs

Tax or fine provides incentive

for owner to reduce pollution

Example: Spreading Positive Externalities

New college built Local business benefit from student

purchases

Workers benefit as businesses expand

Community benefits – taxes collected form students, more skilled and knowledgeable population

local govt. can spend more to provide public goods

govt. tries to increase positive externalities

Subsidy – is a govt. payment that helps cover the cost of an economic activity that is considered to be in the public interest

comes from taxes , so everyone shares the cost

ex. – given to drug companies to develop new vaccine

will benefit the whole community once it is in effect